Structured Notes Overview
Background
Structured investments were first introduced in the U.S. more than 100 years ago. Traditionally, the convertible bond has been the most popular structured product by companies wanting to issue debt more cheaply. In exchange for the potential of a higher return (if underlying share value increased the bond converted to equity at a profit) investors would accept a lower fixed coupon. Over the years, investment banks have added features to this basic fixed-income convertible bond and the issuance of structured notes has quickly grown to over $50 billion per annum.
A “structured note” has no precise definition in a business or regulatory context. The broad definition used by regulators such as the SEC, NASD, and NYSE is “a security derived from or based on another security, basket of securities, index, commodity, or foreign currency.”
SEC Rule 434 provided the following definition for 1933 Act purposes; “securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investors return and the issuer’s payment obligations are contingent on, or highly sensitive, to changes in the value of the underlying assets, indices, interest rates, or cash flows.” Typical structured notes include equity-linked, index-linked, interest-rate-linked, commodity-linked, and hedge fund return-linked securities, which are purchased as Principal Protected Notes, Guaranteed Investment Certificates, or Medium Term Notes.
Structure
Although from a cash flow perspective, a structured note appears to be a combination of a traditional debt instrument and an additional underlying asset, the securities are, in fact, corporate fixed-income Indentures offered pursuant to a registration statement, or pursuant to a private placement (144A) or other exemption (Reg D offering) from registration.
These debt securities constitute a direct, unconditional, unsecured and unsubordinated obligation of the Issuer. The debt securities will rank pari passsu in liquidation with all other unconditional, unsecured, and unsubordinated debt obligations of the Issuer. The structured note Issuers are S&P/Moody’s rated (A, AA, or AAA) financial institutions which represent the highest quality of corporate debt issuers. Only 12 percent of all corporations currently hold an A, AA, or AAA rating causing only one in eight corporate debt issuers to be considered high-grade.
Principal-Protected Notes
A Principal-Protected Note has the same market conventions as a traditional fixed-income security. The Note is assigned a CUSIP or ISIN and settles electronically on a delivery versus payment basis or physically through the settlement bank. Upon issuance of the Note, the purchaser’s depositary will credit on its book entry registration and transfer system, the purchasers’ account with the respective principal or face amount of the security beneficially owned by the purchaser. The issuing investment bank or dealer typically provides a secondary market in the Note and prices are available on a daily basis from the major market data vendors (i.e. Bloomberg). Principal, coupon payments, and other amounts due on the Note will be made to the registered depositary for the benefit of the purchaser by the Issuer.
The only feature that differentiates a Principal-Protected Note from a traditional corporate debt security is the coupon payments and the payment at maturity characteristics.
Interest Rate (Coupon)
Traditional corporate debt security – coupon payment is a function of the issuer’s credit rating and current interest rate environment. A 5 year note issued by an AAA rated corporation currently pays a semiannual coupon of 5.30%
Principal Protected Note - investor receives either a minimal coupon or no coupon for the right to participate in the positive returns of an asset class index or investment strategy.
Examples:
- 5 Year 100% Principal-Protected Commodity Participation Note link to a basket of commodity returns and issued by a AA rated investment bank pays a semiannual coupon of 1.8%.
- 4 Year 100% Principal-Protected Note linked to a basket of global equity index returns pays a zero coupon.
Traditional corporate debt security – return of principal.
Principal-Protected Note - return of principal plus the positive return of asset class index or trading strategy. The redemption value at maturity of the Principal-Protected Commodity Participation Note is the greater of par (100%) or par plus the weighted average performance of the commodity basket components. Similarly, the Principal-Protected Global Index Basket will return the greater of par (100%) or par plus the weighted average performance of the global equity index returns.
Conclusion
Structured notes are providing risk-adverse investors with a highly-rated, conventional fixed-income security which delivers portfolio diversification and upside participation in more volatile asset classes. Similar to convertible bonds, investors rely on the credit worthiness of the issuing bank for the return of their principal and receive a lower fixed-rate coupon in exchange for the potential of higher returns.
THIS DOCUMENT MAY NOT BE USED FOR THE PURPOSE OF, AND DOES NOT CONSTITUTE, AN OFFER OR SOLICITATION BY ANYONE IN ANY JURISDICTION OF ANY INVESTMENT PRODUCTS OR SECURITIES.
This material is for information purposes only. This is neither an offer to sell securities or other instruments nor a solicitation of an offer to buy securities or other instruments nor shall it be deemed to provide investment, tax, accounting or other advice. There is no assurance that a transaction will be entered into on such indicative terms or product structure information. Additional information is available upon request. This material is not intended to set forth the final terms and conditions of any security or transaction and it may be amended, superseded or replaced in its entirety by subsequent term sheets or other summaries of terms and conditions. You should refer to the prospectus or offering document relating to the above potential transaction which includes important information, including risk factors that relate to an investment in the Notes. Transactions of the type described in these materials may involve a high degree of risk and the value of such transactions may be highly volatile. Such risks include, without limitation, risk of adverse or unanticipated market developments, risk of counterparty or issuer default, risk of adverse events involving any underlying reference obligation, entity or other measure and risk of illiquidity. In certain transactions, counterparties may lose their entire investment or incur an unlimited loss. This brief statement does not disclose all the risks and other significant aspects in connection with transactions of the type described in the materials.
Risk Disclosure
Investments in structured products involve counterparty credit risks and client losses may occur. Past performance of structured products is not indicative of their future performance. This material on structured products contains opinions of Roundstone regarding the benefits of structured product investing which may be subjective in nature.
Please see the full Risk Disclosure for a more detailed listing of the risks pertaining to Structured Products.
